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Captive bidding at the auction: How bond vigilantism was swamped - Dave Lewis

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  • Captive bidding at the auction: How bond vigilantism was swamped - Dave Lewis

    Captive bidding at the auction: How bond vigilantism was swamped

    by Dave Lewis
    Time flies when you're making money: 19 years have sped by since the start of the great bond bull market. So traumatic was the preceding bear market (it spanned the administrations of U.S. Presidents from Harry Truman to Ronald Reagan, 1946 to 1981) that fixed-income investors took a pledge: Never again would they be the dupes of a central bank. They would henceforth sell at the first sign of inflation.

    So market interest rates would increase before the U.S. Consumer Price Index could spurt. The Fed might nod off, but the bond market vigilantes pledged they would never sleep again.

    Now look at them. With a generation's worth of capital gains tucked under their ample belts, they are snoring in hammocks or swatting golf balls. Financial markets the world over are worse off for their unannounced retirement. - James Grant
    Many financial commentators have opined on the absence of the "bond vigilantes" from the US Treasury market. Bond traders now willingly accept low yields in the face of broad based commodity inflation, which hitherto would have, according to Mr. Grant, whose views I highly respect, above, inspired significant selling from the now "sleeping" bond vigilantes. I've been doing a bit of checking on the US bond market and think I have a few answers to the question, "where did the bond vigilantes go?," although a better question might be, "whose efforts have swamped bond vigilantism in the Treasury markets?"

    The good old days

    In 1955, US federal debt totaled $234B, of which $163B (70%) was tradable on the open market. The biggest single player was the Fed, which, in 1955, carried $24.4B worth of Treasury Securities on its balance sheet, or just under 15% of marketable debt.

    Is the Fed the culprit?

    Federal Reserve acquisitions of debt rose steadily from 1955 to 1970, when holdings peaked at just over 25% of marketable debt. But, as standard closed system economic theory argues, Fed purchases, i.e. debt monetization, did not keep yields down. 10 year yields rose from under 3% in 1955 to well over 7% in 1970 while consumer price inflation rose from -0.4% in 1955 to 5.7% in 1970. Bond vigilantism was apparently alive and kicking back then and Federal Reserve debt monetization led, as it should, to inexorable inflation.

    Thus, we can chalk off the Fed as player whose efforts swamp bond vigilantism.

    Are the foreigners to blame?

    Of late, the presence of foreign purchasers, in particular, foreign official purchasers, have been cited as a reason behind the lack of bond vigilantism, even (in hindsight, partially erroneously) by me.

    In 1955, foreign official holdings (the foreign private sector was not yet involved) of Treasury debt totaled $5.8B, or 3.6% of marketable debt. Foreigners were not yet players.

    By 1980, this had changed. Foreign official holdings rose to just under 18% of marketable debt, while total foreign holdings rose to 20.4% of marketable debt. Despite this support, 10 year yields rose from 4.2% in 1965, when foreigners began to ramp up their purchases, to well over 12% by 1980. Consumer price inflation rose from 1.6% in 1965 to 13.5% in 1980. The decline in real yields at the back end of the curve, excluding other factors (which is rarely wise), suggests that foreign buying might have kept rates lower than they otherwise would have been, in a closed system.

    Foreign acquisitions of US debt have increased dramatically since 1980. As of Q2 2007, 44% of marketable US Treasury securities are in foreign hands. 31.3% of marketable US Treasury securities are in foreign official hands. The coincident rapid increase in foreign holdings of US debt with a multi-decade decline in yields suggests that these purchases kept yields lower than they otherwise would have been. Yet, the data from the 70s, when bond yields rose despite foreign inflows, suggests that this is not the whole story.

    Enter the captive bidders

    Something besides increased foreign acquisitions of US debt, happened between the early 80s and the present day which slowly but inexorably swamped bond vigilantism. That something was an increase in social security (and related programs) net income which, I argue, dramatically changed the US bond market.

    From 1955 through 1980, the US Treasury market was a mainly open affair, by which I mean, most of the issued debt was marketable. In 1955, non-marketable debt made up 30% of the total and in 1980 non-marketable debt made up 33% of the total. Bond prices were, in the main, set in open markets.

    Captivating the Trust Funds

    In the mid 80s, in accordance with the recommendations of ex Fed Chairman Greenspan's Commission of Social Security (boy this guy's fingers are in a lot of pies), social security taxes were raised which raised the percentage of national income flowing into social insurance programs from 7.2% to 8.5% (source BEA). While a 1.3% increase in national income flow (it amounts to an increase in income from 4.8% of GDP in 1987 to 5.6% of GDP in 2006) is substantial, it doesn't fully explain the substantial rise in social insurance assets.

    If changes to the income side don't fully explain the dramatic rise in social insurance holdings, something must have coincidentally reduced the outflow, which fell from 4.6% of GDP in 1993 to 4.1% in 2006. That something was a change to inflation calculations upon which cost of living adjustments (COLAs) in social security payments are made.

    According to John Williams' Shadow Stats site:
    In particular, changes made in CPI methodology during the Clinton Administration understated inflation significantly, and, through a cumulative effect with earlier changes that began in the late-Carter and early Reagan Administrations have reduced current social security payments by roughly half from where they would have been otherwise. That means Social Security checks today would be about double had the various changes not been made.
    Assuming Mr. Williams' estimate is correct, a doubling of SS outflow from the actual $549B, which produced a SS surplus of $185B, to $1,097B, assuming no changes on the income side, would have created a deficit of $363B. In turn, this would have forced the US Treasury to sell about $800B of securities into the market instead of the $250B they actually sold in 2006. I doubt current US Treasury yields would be at such low levels if such was the case.

    But it is the case. Non-marketable debt has risen from the afore noted 33% of total debt to 49%. That's right, half of Treasury bidding comes from captive bidders. So much for a free and open market in US Treasuries.

    In sum then, the cumulative effects of SS tax hikes, which inflated SS income, and reductions in outflow due to recalculated COLAs are, I believe, the primary cause of our strangely low bond yield environment in the US. As one who has cited with alarm the growth of Chinese reserves to and above the $1Tln mark, I was amazed to find that Social Security holdings have grown even faster, and now total some $2Tln.

    Forget about China's, here's a sovereign wealth fund just waiting to happen.

    But, as the saying goes, it isn't just the size of the ship that matters, the motion of the ocean does as well. Many financial commentators have (rightly so, in my view) worried about diversification out of $s among foreign countries with large reserves, yet few worry about a similar risk consciousness coming from within the US.

    Imagine a financial world in which the managers of the SS Trust were able to diversify out of US assets. Minimally imagine a financial world in which the managers of the SS Trust were able to pick and choose amongst domestic investments. In that world, I doubt the chosen mix would be (as is currently the case) a virtually all US Treasury portfolio with an average interest rate of 5.2% and duration of 7.2 years. Simply shifting to a much shorter duration fund would cause the US yield curve to steepen dramatically.

    Captive bidders and the Enron effect

    That is, I argue, the captive nature of the SS Trust fund in conjunction with its size has been the main cause which engendered our low and reasonably flat curve yield environment. For it is the US Treasury itself which manages these funds. As those who lost all their retirement funds at Enron could tell you, captive trust funds invested in the company itself does not a diversified portfolio create- just the opposite effect is, in fact, created. When foxes (invariably from Goldman Sachs these days) guard the chicken coop, ultimately you have no chickens.

    This too, however, shall pass. According to the SSA (Social Security Administration) by 2017, barring any further increases in taxes or calculation changes in COLAs, outgo will exceed income for SS and DI (Disability Insurance). National Health Insurance (HI) costs will deplete the funds even more rapidly. By 2041 SS and DI will have exhausted their funds and by 2019 HI funds will be depleted. So, within a decade there will no longer be additional surplus funds to be used to purchase US bonds which will have to then be sold on the open market. Call it peak SS Trust Funds, although peak trust might be even more apt.

    In Greenspan we trusted

    It is, perhaps, fittingly ironic that the same Greenspan who bemoans increased federal spending, recommended and oversaw the conditions which allowed such spending to occur outside of a free market mechanism. The same man who proclaimed, in his oft cited, Gold and Economic Freedom:
    In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

    This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.
    Greenspan oversaw a tremendous confiscation of wealth, but not from the wealthy–from the common man. He has repeatedly said that he still stands by the views he expressed back in 1966 and I believe him. He (and others) used the lack of a monetary standard to confiscate wealth from us- wealth which was used, inter alia, to finance the current wars. Atlas, in this case, didn't shrug, he stole.

    I expect, as increases in trust fund surpluses slow, US interest rates will rise, most likely dramatically in the years to come.

    Dave Lewis studied Philosophy and Physics at Cornell; started trading at a small "black box" CTA in 1987; traded FX and FX Options at Chase; traded FX, FX Options and futures at Moore Capital (more execution than trade origination); designed the first FX Options on-line (Reuters/Telerate) commentary service for Thomson Financial in 1993; designed a similar service for IDEA. Managed IDEA Singapore which included consultation services for most of the Asian CBs and Treasury Departments. He started his own on-line consulting company in Singapore which was purchased by 4CAST. He retired in 1999 and since then has managed his own account and home schools his son. You can read his blog at http://dharmajoint.blogspot.com


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    Last edited by FRED; 10-05-07, 01:02 PM.
    Ed.

  • #2
    Re: Captive bidding at the auction: How bond vigilantism was swamped

    Great editorial. Thanks.


    There has been some commentaries written a while back noting the peculiar rise of T-Bill purchases by Caribbean money center countries. It was noted that the rise in purchases from the Caribbean locations always seemed to offset declines in purchases from other major foreign buyers. The author was speculating that these unusual Caribbean purchases was actually the Federal Reserve trying to hide the fact that it was monetizing debt and keeping rates artificially low by creating artificial demand and hiding who the true purchaser of the T-Bills is. Any thoughts on this?

    I found this editorial written in 2005 about this topic, but I think there are other that are more receint:
    http://www.financialsense.com/fsu/editorials/kirby/2005/0318.html
    Last edited by dbarberic; 10-05-07, 02:26 PM.

    Comment


    • #3
      Re: Captive bidding at the auction: How bond vigilantism was swamped

      This is a good thesis, but it's Something we discussed before, and the Gave-Kak hypothesis is a good one too , IMHO

      Anyone have any more guesses, please add them

      http://www.itulip.com/forums/showthr...bond+conundrum

      low bond yield explanations - let's count them up
      I'm aiming here to get more possible explanations, not to pick the evildoers (that may come later). So please add more possible explanations, and correct me where I'm wrong about someone's position. The question mark means I think this is the person who originated this idea, but I can't be sure it's their original work

      1. Rosenberg? Too few investment vehicles available because of IMF rules from the 1970s onward

      2. Bernanke? worldwide savings glut

      3. Gave-Kal- in the past, vast amounts of capital have been regularly wiped out by large-scale wars (WWI and II, Cold War). We are now in a situation where vast capital has not been destroyed for some time. (this appears to me to be a variation on (2.) above - savings glut, but a different explanation from where the glut is coming from).

      4. Richenbacher/Daughty/Goldbugs/Bonner
      Greenspan/Bernanke, liquidity

      5. Noland - Central bank (but with lower emphasis than those in 4. above) liquidity and private liquidity, derivatves, leverage

      6. Harry S Dent - demographics, demographics, demo ... . I'm unclear as to exactly what mechanism he proposes for bond yields being forced down by aging boomers, 10 years before their retirements. Oh, Dent's calling for DOW 15,000 in early 2008 and 20,000 late 2009.

      Prechter? - does he offer an explanation?

      Niederhofer - does he offer an explanation? All I get out of Niederhofer is (insult Buffet) then "free enterprise conquers all, buy the dips" (insult Buffet again) "1000% over the course of the century" (insult Buffett again).

      (isn't it interesting that a lot of the "official" explanations are uni-variate/mono-causality ? Or are the official explanations more complex, but reported simplistically by the nuance-challenged media? )

      99. me? (the ? means "is this combination of things unique to me)
      1. reduced friction (electronic trading),
      1a. automated, real-time arbitrage in a vast array of goods and services
      1b. massive, massive carry trades
      2. worldwide liquidity, both private and CB
      3. worldwide (seemingly everyone but a few holdouts) alignment of government and central bank objectives, tools, techniques, agendas and orthodoxies (China and Japan and India and Korea and Germany and Britain and Saudi Arabia and the US all agreeing on monetary beliefs and actions)
      4. "insurance"
      5. leverage and Minksy-type "feel good, take more risks - the risks don't materialize, feel better, take more risks - the risks do materialize, the CB bails you out, feel better, take more risks)

      Comment


      • #4
        Re: Captive bidding at the auction: How bond vigilantism was swamped

        Originally posted by dbarberic View Post
        Great editorial. Thanks.

        There has been some commentaries written a while back noting the peculiar rise of T-Bill purchases by Caribbean money center countries. It was noted that the rise in purchases from the Caribbean locations always seemed to offset declines in purchases from other major foreign buyers. The author was speculating that these unusual Caribbean purchases was actually the Federal Reserve trying to hide the fact that it was monetizing debt and keeping rates artificially low by creating artificial demand and hiding who the true purchaser of the T-Bills is. Any thoughts on this?

        I found this editorial written in 2005 about this topic, but I think there are other that are more receint:
        http://www.financialsense.com/fsu/editorials/kirby/2005/0318.html


        Although there's a possible connection between the Fed and Caribbean banks, the Treasury International Capital reports only show a two month spike in 2005, and nothing significant since.

        http://www.NowAndTheFuture.com

        Comment


        • #5
          Re: Captive bidding at the auction: How bond vigilantism was swamped

          Originally posted by Spartacus View Post

          Anyone have any more guesses, please add them

          Mine is close to EJ's (nice job EJ!) and is based on John Williams work too.

          It's simply that the real interest rate, after adjusting for real inflation per John's work, is very negative - about minus 5-6%. Once the real truth about starts to get out there and the Fed & Wall St. lose control of inflationary expectations, the "vigilantes" will be back.
          It may have started with the recent 50 bps cut in Fed Funds...



          All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.
          -- Arthur Schopenhauer (1788-1860)


          "Find the trend whose premise is false, and bet against it."
          -- George Soros
          http://www.NowAndTheFuture.com

          Comment


          • #6
            Re: Captive bidding at the auction: How bond vigilantism was swamped

            Originally posted by bart View Post
            Mine is close to EJ's (nice job EJ!) and is based on John Williams work too.

            It's simply that the real interest rate, after adjusting for real inflation per John's work, is very negative - about minus 5-6%. Once the real truth about starts to get out there and the Fed & Wall St. lose control of inflationary expectations, the "vigilantes" will be back.
            It may have started with the recent 50 bps cut in Fed Funds...



            All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.
            -- Arthur Schopenhauer (1788-1860)


            "Find the trend whose premise is false, and bet against it."
            -- George Soros
            That (chronic very negative real interest rates) would seem to explain the rising gold price through the most recent Fed "tightening" phase. If they were behind the curve the whole way then real interest rates never went positive. Hell, this sounds better than the BoJ's ZIRP.

            Comment


            • #7
              Re: Captive bidding at the auction: How bond vigilantism was swamped

              Originally posted by GRG55 View Post
              That (chronic very negative real interest rates) would seem to explain the rising gold price through the most recent Fed "tightening" phase. If they were behind the curve the whole way then real interest rates never went positive. Hell, this sounds better than the BoJ's ZIRP.
              The Fed has and will continue to stay behind the curve.

              "Here's how I think things will play out: first a stock market crash when one or more of the assumptions is exposed as false, and then serious inflation as the Fed tries to revive the economy. (In thinking this, I am following Eric Janszen, of iTulip fame.)"

              Andrew Huntington 17 Jul 2007 02:45
              Ed.

              Comment


              • #8
                Re: Captive bidding at the auction: How bond vigilantism was swamped

                Originally posted by Fred View Post
                The Fed has and will continue to stay behind the curve.

                "Here's how I think things will play out: first a stock market crash when one or more of the assumptions is exposed as false, and then serious inflation as the Fed tries to revive the economy. (In thinking this, I am following Eric Janszen, of iTulip fame.)"

                Andrew Huntington 17 Jul 2007 02:45
                That quote is from one of iTulip's members, ASH, I believe, the PhD Marine Lance Corporal as I recall.
                Jim 69 y/o

                "...Texans...the lowest form of white man there is." Robert Duvall, as Al Sieber, in "Geronimo." (see "Location" for examples.)

                Dedicated to the idea that all people deserve a chance for a healthy productive life. B&M Gates Fdn.

                Good judgement comes from experience; experience comes from bad judgement. Unknown.

                Comment


                • #9
                  Re: Captive bidding at the auction: How bond vigilantism was swamped

                  Originally posted by Jim Nickerson View Post
                  That quote is from one of iTulip's members, ASH, I believe, the PhD Marine Lance Corporal as I recall.
                  Quoting the original source:

                  "Once the Fed gets firmly ahead of deflation, it may soon find itself behind the curve on inflation, chasing inflation up the yield curve just as it is today. Except that this time the inflation may be more extreme and will occur after only a brief lag versus several years, as was the case of the reflation program that started in 2000 and ended in 2004. This is because—unlike the previous three bubble cycles, which were each characterized by ever-growing internal deflationary pressures and external inflationary pressures—the wall of dollars ready to flood back to the U.S. is far bigger and more skittish. The fact that deflationary internal pressures can in fact be relieved via inflation will come into play on the policy side of the equation. More on that later."

                  ericjanszen [Trident Capital] | POSTED: 04.13.05 @00:30
                  Ed.

                  Comment


                  • #10
                    Re: Captive bidding at the auction: How bond vigilantism was swamped

                    Originally posted by GRG55 View Post
                    That (chronic very negative real interest rates) would seem to explain the rising gold price through the most recent Fed "tightening" phase. If they were behind the curve the whole way then real interest rates never went positive. Hell, this sounds better than the BoJ's ZIRP.
                    Indeed... and it just so happens that I have a chart showing gold vs. real interest rates, and its even tradeable.


                    http://www.NowAndTheFuture.com

                    Comment


                    • #11
                      Re: Captive bidding at the auction: How bond vigilantism was swamped

                      bart,
                      is that chart on your website? i'd like to follow it, but can't find it over at nowandfutures.com.

                      edit: just found it. obviously i've got to spend more time nosing around your site.

                      Comment


                      • #12
                        Re: Captive bidding at the auction: How bond vigilantism was swamped

                        Originally posted by jk View Post
                        bart,
                        is that chart on your website? i'd like to follow it, but can't find it over at nowandfutures.com.

                        edit: just found it. obviously i've got to spend more time nosing around your site.

                        I did also just add it back to my forecast page under the gold section. I hadn't been keeping up on drawing in the various trend lines.

                        One of these days I'll actually get around to creating a few more pages to host more of my charts. There are literally hundreds of them that are only accessible via an inconvenient set of recap pages.
                        http://www.NowAndTheFuture.com

                        Comment


                        • #13
                          Re: Captive bidding at the auction: How bond vigilantism was swamped

                          I would believe this except it raises the hard question, how come the current bond market doesn't see it?

                          All those wall street quants, all that research horsepower, and it yields no wisdom? (just a question, not argument by incredulity)

                          Originally posted by bart View Post
                          Mine is close to EJ's (nice job EJ!) and is based on John Williams work too.

                          It's simply that the real interest rate, after adjusting for real inflation per John's work, is very negative - about minus 5-6%. Once the real truth about starts to get out there and the Fed & Wall St. lose control of inflationary expectations, the "vigilantes" will be back.
                          It may have started with the recent 50 bps cut in Fed Funds...



                          All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.
                          -- Arthur Schopenhauer (1788-1860)


                          "Find the trend whose premise is false, and bet against it."
                          -- George Soros

                          Comment


                          • #14
                            Re: Captive bidding at the auction: How bond vigilantism was swamped

                            Originally posted by Spartacus View Post
                            I would believe this except it raises the hard question, how come the current bond market doesn't see it?

                            All those wall street quants, all that research horsepower, and it yields no wisdom? (just a question, not argument by incredulity)


                            I don't have a straight answer, but among the good possibilities are vested interests, no big motive to see it and plenty of motive to ignore it, the lack of understanding of Austrian economics, the madness of crowds, the purpose of Wall St. is not to tell the full truth but to make money for Wall St., "encouragement" from the Fed and the BLS and Wall St.... and you could probably come up with more... although perhaps not as cynical as some of mine. ;)

                            Rhetorical questions too - how many did not see the stock and bond market bottom in 1982 and didn't get in until the mid '90s, and how many bought gold and silver in 1971, 1975 or even 2001-2003, and how many got out of stocks around 2000?
                            In other words, there were plenty of signs and facts about the actual truth but few saw or were willing to see them.
                            http://www.NowAndTheFuture.com

                            Comment


                            • #15
                              Re: Captive bidding at the auction: How bond vigilantism was swamped

                              Quote:
                              Originally Posted by Spartacus
                              I would believe this except it raises the hard question, how come the current bond market doesn't see it?

                              All those wall street quants, all that research horsepower, and it yields no wisdom? (just a question, not argument by incredulity)



                              On the institutional side, Bart has got it.

                              On the consumer side, cognitive dissonance.

                              That's where you see something but you just can't understand it.

                              After 20+ years of 'nothing but up', many people just don't understand that their views on the market are fundamentally flawed.

                              iTulip has numerous posts looking at how this psychology could change - many of them relating to the '7 stages of denial' methodology.

                              Comment

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